No federal licenses required to mine or trade, although state licenses may soon be necessary

Bitcoins are a popular decentralized digital "cryptocurrency", an encryption-based form of virtual currency. Based on proof-of-work on the SHA-256d hash, the digital payment form pioneered the field for later cryptocurrency, when it was launched by a programmer or group of programmers calling themself "Satoshi Nakamoto". Even with the emergence of several competitors, Bitcoins remain the world's most-used cryptocurrency, with the current global pool of Bitcoins estimated to be worth $10.89B USD at current exchange rates.

For all the excitment, it's a rather confusing time for those who mine or invest in Bitcoin, in terms of what to expect in the U.S. in terms of taxation and regulation.

I. "Clairifications" Answer Some Questions, Raise Others

Currently federal taxation of Bitcoin income is anything but clear. Bitcoins' backers are still in the dark in the U.S. as to whether the U.S. will treat the popular cryptocurrency like a foreign currency (less taxes) or like capital gains from investment (more taxes).

The releases contain some mistakes. For example the second release says at one point:

Virtual currency does not have legal tender status in any jurisdiction.

...which appears to be misinformation, as Germany does regard Bitcoins as "a currency".

Bitcoins are recognized as legal tender in Germany, but are considered speculative capital investments in other regions. Some nations have moved to band Bitcoins entirely.
[Image Source: Bit-Square]

What makes this statement more ironic is that a government report already noted that Bitcoin enjoys "legal tender" status as a "foreign currency" in several countries, including Germany. The report was ordered by Sen. Thomas Richard "Tom" Carper (D-Dele.) and the U.S. Senate Governmental Affairs Committee. Performed by the Law Library of Congress's Congressional Research Service, the study [not yet released to the public] surveyed 40+ countries on their Bitcoin-related laws, policies, and other forms of regulation (or lack thereof).

Of those countries surveyed, only a very few, notably China and Brazil, have specific regulations applicable to bitcoin use. There is widespread concern about the Bitcoin system’s possible impact on national currencies, its potential for criminal misuse, and the implications of its use for taxation. Overall, the findings of this report reveal that the debate over how to deal with this new virtual currency is still in its infancy.

This report has some good news – namely that the United States may not be as far behind the curve on virtual currencies as some have argued. In fact, the United States might be leading the way for a number of nations when it comes to addressing this growing technology. While there is no consistent or clear definition or treatment of digital currencies throughout the world, this report underscores that Bitcoin and other virtual currencies are present and growing in major economies, supporting the call for increased global cooperation.

It is unclear why the FinCEN was unaware of Germany's Bitcoin status in light of the recent, salient report.

The "clarifications" also leave some questions open. For example, it says that mining individuals and corporations are exempt from having to register as money traders. But what about nonprofits?

It would seem they too would be exempt from having to file, but such a policy was not explicitly stated.

II. Recent Arrests Highlight Money Laundering Concerns

Currently it is clear that Bitcoin exchanges must register with the FinCEN and obey federal laws, including not accept business transactions used for money laundering. That policy was highlighted earlier in the week when Robert "BTCKing" Faiella, 52, was arrested and accused of running an unregistered, illegal exchange to launder criminal cash for Bitcoins. The underground exchange was affiliated with the black market site Silk Road, a site which saw several prolonged service outages due to law enforcement pressure last year.

A second man, Charlie "Yankee" Shrem, 24, chief executive officer and compliance officer at the Bitcoin exchange company BitInstant.com, was also arrested. The arrest sent shockwaves through the Bitcoin enthusiast community as Mr. Shrem was a vice president of The Bitcoin Foundation, an independent group who handles the evangelizing of Bitcoin worldwide.

Mr. Shrem used "his position in both the old banking world and new, alternative currency world to help pave the way for the Bitcoin economy to emerge in early 2011," according to a biography posted previously on the Bitcoin Foundation's website.

In a statement Jinyoung Lee Englund, a spokeswoman for The Bitcoin Foundation remarked:

We are both surprised and saddened to learn of these allegations. The
foundation does not condone illegal activities and values transparency, accountability and a high level of responsibility towards its members and overall community.

We've seen all too clearly that digital currencies can be an effective tool for individuals seeking to engage in illicit activities and this recent arrest underscores that vulnerability. As we learned from our hearing late last year, law enforcement, including the FBI, Drug Enforcement Agency, and others are focused on ensuring that those who want to use digital currencies for harm are stopped. I commend their tireless work to protect our citizens and the rule of law.

That being said, there are many who believe that digital currencies are an important and valuable new technology, and who want the opportunity to play by the rules in bringing potentially valuable products to the marketplace.

That’s why it’s critical that the federal government, including Congress, takes notice and learns more about the potential promises and risks of this emerging technology and develop thoughtful and sensible policies that protect the public without stifling innovation and economic growth.

Mr. Shrem resigned his post at The Bitcoin Foundation.

III. New York and California Eye "BitLicenses"

Bitcoin has elicited mixed reaction from regulators, both in the U.S. and abroad. Germany, Turkey, and India regard the Bitcoin as a currency (of sorts) in terms of taxation, and hence due not charge capital gains taxes on casual trading. Other regions -- including Canadaand Norway -- say that Bitcoins are more of a speculative investment than a true "currency". This allows these regions to treat proceeds of Bitcoin sales as capital gains income, and tax Bitcoin enthusiasts at a higher rate.

Calif. and New York are deciding whether you should need a license to do business related to Bitcoin. [Image Source: Bitcoin Examiner]

At issues is the "announcement" process associated with mining and peer-to-peer Bitcoin transfers. The harshest critics argue for a very strict interpretation, in which every user is viewed as a money-transmitter and must seek a license. Such an intrepretation would basically kill the Bitcoin.

Slightly more measured critics argue that companies, at least, constitute money transmissions if they deal with Bitcoin, regardless of if they exchange the cryptocurrency for other forms of payment. Such a policy would likely stymie, but not flat-out kill the Bitcoin.

Lastly, Bitcoin advocates argue that individuals and companies should be exempt of onerous and expensive money transmitter licensing. They argue such a policy would lead to more local business.

Some want anyone involved with Bitcoin to have to be licensed by U.S. states.
[Image Source: Josh Romero, et al.]

The state of New York is also cracking down on Bitcoin. New York's superintendent of financial services, Benjamin Lawsky, last year issued subpoenas to Bitcoin mining and investing startups, forcing them to spend their scarce seed money on hiring lawyers to craft legal replies. His office is discussing requiring "BitLicenses" -- money transmission licenses -- for any company that mines, invests in, or develops software to work with Bitcoins.

Bitcoin advocates aren't wholly opposed to the BitLicense idea, but in a recent hearing they argued that it is vital to give "safe harbor" to new startups and offer them help and understanding when navigating through the licensing process. Some -- such as Cyrus Vance, a New York County district attorney -- are arguing against safe harbor, saying that regulators should solely be focused on cracking down on the currency, not assisting businesses seeking licenses.

IV. Bitcoin Has Won Some Powerful Allies

While Bitcoin is a disruptive force in the payment market, challenging traditional credit card firms like Visa Inc. (V), it does have some high profile backers. Sir Richard Branson, owner of the UK's Virgin Group, has come out as a supporter of the Bitcoin. And the Winklevoss twins of Facebook Inc. (FB) fame/infamy have invested in a number of Bitcoin startups -- including BitInstant.

At the New York state hearing last Friday, Cameron Winklevoss acknowledge the "Wild West" analogy often used to describe Bitcoin was somewhat apt, commenting:

The Wild West attracts cowboys. A sheriff would be good thing... [but] over-regulation could cripple its development.

Fred Ehrsam, a former Goldman Sachs Group Inc. (GS) trader turned heads when he left the financial powerhouse to cofound a San Francisco, Calif.-based Bitcoin startup, Coinbase. His company helps users buy and sell Bitcoins. He's been carefully following the regulation efforts. he says that whatever example New York and California set, other states are likely to follow.

We think California and New York will set the tone for everything else. When that tone is established, we're ready to hand in licensing applications immediately.

Mr. Ehrsam's work to legitimize and promote Bitcoin recently won him the distinction of being listed one of TIME magazine's "30 Under 30", which honors influential people worldwide under the age of 30.

Meanwhile, at the federal level, the biggest unanswered question is whether taxpayers should anticipate Bitcoins being reclassified as an investment. For now, in the absence of clear policy from the U.S. Internal Revenue Service (IRS), large Bitcoin investors would be wise to pay taxes on their Bitcoin earnings similar to what they would from currency trading (not the higher capital gains rates paid for day trading stocks). Tax professionals should be able to help large investors with doing this.

You would also have to have a giant EMP erase all offline hard drives and flash drives the world over while you are at it. So unless someone has one of those that can penetrate all materials the world over, I wouldn't be too worried.